Bitcoin: Bringing you up to speed on a digital currency

by DLA Piper
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How would you like to pay for that? Cash, credit or bitcoins?

While the use of Bitcoin may not presently be widely accepted like cash or electronic funds transfers, it is undeniable that the interest and market opportunities for Bitcoin are rapidly increasing.

Bitcoin is a decentralised peer-to-peer payment system that exists virtually and is unlimited by the constraints of countries, government or time. The payment system's unit base, bitcoins, are essentially a 'digital currency' or cash for the digital era. With a global market capitalisation of almost AU$9 billion (as at 7 July 2014), Bitcoin continues to grow in popularity around the world, as individuals and companies alike adopt it into mainstream transactions. Some common examples in Australia include using bitcoins to pay for food and drinks in a growing number of pubs, restaurants, patisseries and cafes. Recent reports have indicated that you can use bitcoins to purchase an off-road car or even put down a deposit on a house.

The important bits - key terms

  • Bitcoin: an online, decentralised peer-to-peer payment system.
  • bitcoins (lower case 'b'): the basic 'digital currency' units used in transactions through the Bitcoin system. The symbol for bitcoins is 'BTC' (e.g. 10 BTC is ten bitcoins). A 'satoshi' is 0.00000001 of a bitcoin and is its lowest unit.
  • Block chain: a digital ledger of every bitcoin transaction ever executed.
  • Mining: the solving of computational problems which are essentially used to verify bitcoin transactions on the block chain. 'Miners' may receive a reward in bitcoins for mining. 

What are the benefits of using bitcoins?

Some of the key benefits of accepting bitcoins include:

  • Convenience: bitcoins are portable and allow users to make mobile payments almost instantaneously using an online bitcoin wallet. Cross-border transactions take only minutes.
  • Reduced transaction costs: by removing the need for intermediary parties, the Bitcoin system greatly reduces transactional costs that are otherwise present in conventional credit card transactions or electronic funds transfers.
  • Marketing: because Bitcoin allows users to make mobile payments, businesses are able to make use of QR codes to facilitate online payments. Given Bitcoin's growing adoption rates, businesses that have started accepting bitcoins have also enjoyed increased media exposure.

What are the risks of using bitcoins?

Using bitcoins could present the following risks:

  • Price volatility: the bitcoin market price is notoriously volatile, creating uncertainty in its practicality as a store of value.
  • Irreversible transactions and limited accountability: bitcoin transactions cannot be reversed and there is limited accountability or recourse available should user disputes arise through use of the system.
  • Compliance and regulation: there is currently little direction in Australia on how to use bitcoin in a manner that complies with existing legislative regimes, such as money-laundering and counter-terrorism laws. Regulation in this regard will ultimately impact on how widely the digital currency is adopted. See our article on the regulation of bitcoins in the Chinese market, and our article on the tax treatment of bitcoins in the United States.

What are bitcoins and where do they come from?

A bitcoin is a digitally signed message comprised of a sequence of letters and numbers (a string of computer code). Broadly speaking, users can acquire bitcoins in three ways:

  1. Cash: bitcoins can be purchased at a market rate through a bitcoin exchange or at a bitcoin ATM. However, bitcoin ATMs in Australia presently only allow you to deposit cash for bitcoins (ie you cannot make cash withdrawals).
  2. Accept payment: a business can accept bitcoins in exchange for goods and/or services.
  3. Mining: users (or 'miners') can contribute computational power to the Bitcoin system's verification process, and in return, receive a bitcoin reward (currently 25 BTC, although this number is due to halve in 2016 and will continue to halve at approximate 4 year intervals).

Bitcoins allocate a numerical value to a user's online bitcoin wallet (account). Users can generate a bitcoin wallet through a mobile app or computer program, enabling them to send and receive bitcoins. Each bitcoin wallet is identified by a public key (an address) and protected by a private key (a password or digital signature). If you lose your private key, there is unlikely to be any other way of accessing your bitcoin wallet and its contents. Transacting with bitcoins is like forwarding an email with a cash attachment.

However, unlike when Australia's federal bank, the Reserve Bank of Australia, prints and issues money, no government authority determines when to do the same for bitcoins. Instead, bitcoins originate through the 'mining' process. At the core of the Bitcoin system is a virtual ledger of every bitcoin transaction known as the 'block chain'. Mining involves solving computational problems which verify bitcoin transactions on the block chain. These computational problems are generated by the Bitcoin system when transactions occur between bitcoin wallets. By verifying that each bitcoin transaction is authentic, bitcoin 'miners' receive a reward in bitcoins. There is a finite supply of 21 million bitcoins that are being gradually released through the mining process; approximately 12 million of these are already in circulation.

A transaction will not clear unless it is authenticated on the block chain; the security of the entire Bitcoin system is protected in this way, as it prevents the same bitcoin being spent twice. The Bitcoin system is therefore largely unregulated in the traditional sense and is powered by its users with no central authority.

Why is Bitcoin here to stay and how could it affect your business?

Bitcoin could dramatically alter the way businesses and consumers pay for goods and services, as well as how businesses advertise. Bitcoin's use of mobile payments, lower transactional costs and fees, online accessibility and increasing consumer availability could see it make significant inroads into challenging conventional payment systems.

The demand for peripheral Bitcoin products is also growing, including technology-based services such as counter-party identification software and enhanced encryption/password protection systems. In the financial sector, the emergence of Bitcoin exchanges has also opened the market for Bitcoin credit services, bitcoin-only derivatives trading platforms, insurance, escrow services and exchange-traded funds.

Bitcoin also has breadth for application beyond a payment system or speculative "commodity". In particular, its innovative block chain structure removes the need for intermediary parties. This can lower costs and potentially improve confidence and efficiency in asset transfers.

However, Bitcoin is not without controversy. Bitcoin has been affiliated with black market sales and illegal conduct. The Silkroad.com prosecutions in the US, and recent dispute surrounding the bankruptcy of the MtGox Bitcoin exchange in Japan are but a few examples. Yet the collective use and understanding of Bitcoin is maturing. Confidence in its use should increase as regulation develops a framework for Bitcoin's operation, when we may see capabilities far beyond its uncertain beginnings.

What are the legal implications of Bitcoin?

One common question is whether bitcoins are actually currency or property. The treatment of bitcoins as either a currency or a type of personal property right has widespread implications for its use in the future. It is only a matter of time before Australia’s government bodies and legislature provide further insight into how bitcoins will be classified legally.

Another controversial area is the tax treatment of bitcoins, particularly around GST. Read our earlier article on bitcoins and GST. The good news is that the Australian Tax Office is expected to provide guidance soon.

Stay tuned

Bitcoin is likely to reshape the way parties interact and transact with each other. Stay tuned for more DLA Piper articles on the developments of Bitcoin.

 

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